AFTER selling her house five years ago, L. Yerkes, a 70-year-old widow and real estate agent in Washington State, said she did not think twice about where to invest the proceeds. As she had done for 30 years, she put her money into securities issued by Metropolitan Mortgage and Securities, a financial services firm in Spokane known for its down-home dependability and generous contributions to community organizations.

As it turns out, Ms. Yerkes's trust -- and that of 35,000 other local investors -- was misplaced. Late last year, Metropolitan and a subsidiary, Summit Securities, stopped paying interest on some $600 million of securities, mostly debt. Then, in January, Ernst & Young, the companies' auditor, resigned, saying it had found "material misstatements" in their financial reports going back three years. On Feb. 4, both companies filed for bankruptcy protection.

"The company looked like a good company," said Ms. Yerkes, who asked that her given name not be disclosed. "All these folks that have invested with the company for years and years -- everybody trusted what they were being told. With people's money at stake, where in heck were the regulators at, and the people who are supposed to keep an eye on this?"

Roughly 2,500 miles away, actually. Because of a federal law intended to streamline securities regulation, the toughest cops on Metropolitan's turf -- officials in Washington State's department of financial institutions --were essentially taken off the beat in 2000. Under that law, Metropolitan's main regulators were now in the other Washington, the nation's capital. In the years that followed, state regulators, who had kept Metropolitan on a short leash, could only watch in fear as the company sold more securities -- preferred stock and debt instruments -- than it could easily repay.

To critics, the failure to protect investors in Washington State is Exhibit A for why state regulators should stay in the oversight mix. Indeed, the debacle goes to the heart of the escalating battle between local and national officials over who should police financial institutions.

Deborah R. Bortner, the director of securities in Washington State's department of financial institutions, was among the regulators who were thwarted in the Metropolitan case. "This is a really good study," she said, "of what happens when they take the tools out of the hands of a group of regulators that have a lot of interest in the companies that are offering securities locally -- out of the hands of a regulator that is overseeing the company closely and into an environment where the oversight is diminished greatly."

Officials at the Securities and Exchange Commission acknowledge that investors were burned by Metropolitan, but deny that the case represents a regulatory lapse.

In the 70 years since the federal securities laws were written and the S.E.C. was created, there has always been some competition between national and state regulators. But the friction has increased considerably since Eliot Spitzer, the New York attorney general, began looking into conflicts of interest on Wall Street and abusive practices by mutual fund companies. The investigations by Mr. Spitzer and regulators from other states have lent credence to the view that federal regulators have recently been less vigilant than some of their state counterparts in supervising financial companies.

NOT surprisingly, as Mr. Spitzer and other state officials have grabbed headlines, financial firms have protested their involvement. Sometimes quietly, sometimes overtly, powerful financial institutions have lobbied hard in recent years to reduce the purview and power of state regulators. They typically argue that the patchwork of state and federal laws is inefficient and costly and that federal oversight should take precedence.

But many experts say investors need protection from all corners. "One of the unique areas of expertise that states have is particular knowledge of the local turf and the local players," said Lewis D. Lowenfels, a lawyer at Tolins & Lowenfels in New York and an authority on securities law. "The dominant policy underlying the regulation of the U.S. securities markets is the protection of the investing public. And this policy is best served when both federal and state regulators implement and apply their particular areas of regulatory expertise and bring them to bear on a specific problem."

The story of how Metropolitan Mortgage and Securities in Spokane slipped from the grasp of state regulators appears to buttress that view.

The Metropolitan Financial Group of Companies was founded in 1953 by an entrepreneur named C. Paul Sandifur Sr. It started as a buyer of home mortgages that other companies would not touch. In the late 1980's, the company branched out, developing commercial property, selling real estate and offering commercial loans, annuities and other investment products. By last summer, Metropolitan's assets had soared to $2 billion; its nine subsidiaries included a brokerage firm and an insurance company called Western United Life Assurance. Western, which is overseen by state insurance regulators, is not affected by the bankruptcy filing of its parent.

As Metropolitan Financial grew, so did its profile in the community. A historic theater owned by the company, the Metropolitan Performing Arts Center, is home to the Spokane Opera. Last April, C. Paul Sandifur Jr., 62 -- the founder's son who became chief executive in 1991 but resigned recently -- gave money to a group that is building a bridge for hikers and cyclists across the Spokane River. It will be known as the Sandifur Memorial Bridge.

Although Metropolitan listed some of its securities on public exchanges in 2000, it remained controlled by the Sandifur family. Mr. Sandifur did not respond to repeated phone calls seeking comment for this article. The company also declined numerous interview requests.

As Metropolitan expanded throughout the 1990's, state regulators kept a tight rein on the company, making sure that its operations would generate enough cash to repay investors who bought its debentures, a form of unsecured debt. It was watched closely because similar companies that sold unsecured debt instruments to the public had run into trouble in previous decades, leaving investors with losses.

By 1995, Metropolitan's earnings were not keeping pace with its mushrooming assets and liabilities. State regulators began to view the company as undercapitalized, Ms. Bortner said, largely because Metropolitan paid almost all its earnings in dividends to its controlling stockholders, the Sandifur family. So regulators put limits on the amount of money Metropolitan could raise through sales of debentures and preferred stock. The company's retained earnings, the amount not paid in dividends, rebounded.

Metropolitan chafed under the restrictions, said Ms. Bortner. State regulators soon conducted an extensive examination of the company and found that it was not complying with the rules. They imposed new restrictions on its ability to sell debentures.

BUT as local watchdogs were cracking down on Metropolitan, lawmakers on Capitol Hill were laying the groundwork that would allow the firm to sidestep state regulators. In 1996, Congress passed the National Securities Markets Improvement Act, which realigned regulatory responsibilities so that larger national issuers of securities would receive federal oversight while smaller local issuers would continue to be under the watch of state regulators.

A part of the 1996 law gave companies whose securities traded on national exchanges an exemption from having to gain state officials' approval for securities sales. The idea was that the stringent listing standards imposed by exchanges would provide adequate protection for investors. But the rule did not prevent states from filing fraud charges against companies in their jurisdictions.

Four years later, Metropolitan would seize the opportunity presented by the new law. In 2000, with state regulators again limiting its ability to raise money, the company issued $25 million of 9 percent notes to investors and listed them on the Pacific Stock Exchange. By doing so, the company broke free of the state regulators' restrictions. Its front-line regulators were now the Pacific Stock Exchange and the S.E.C. in Washington, D.C.

Indeed, in a letter to its state regulators, Metropolitan noted that one reason for listing its securities on the Pacific exchange was to change "the securities regulations we would operate under from the state of Washington Debenture Act to the national securities laws."

Ms. Bortner said she was not surprised when Metropolitan took advantage of the new law. "This company had a history of a C.E.O. who didn't want to be regulated," she said. "Some companies like regulation. But at others, all they can think about is reducing the cost of compliance and regulation and turning that into earnings, regardless of how that hurts investors."

As superintendent of banks in New York from 1977 to 1982, Muriel Siebert, now the president of her own brokerage firm, saw this kind of behavior at some institutions, she said. "There is what Senator Proxmire used to call competition in laxity," she said, referring to William Proxmire, the Wisconsin Democrat who was chairman of the Senate Banking Committee and a critic of wasteful government spending. "If one regulator won't let you do something, you go to the other one."

Compared with the state's requirements, those of the Pacific exchange were much less rigid: a net worth of $4 million, net income of $400,000 or more and pretax income of $750,000, an ability to meet interest and principal payments when due, a combined market value and principal amount of at least $20 million, and at least 100 securities holders. Most significant, Metropolitan no longer had to abide by the state's limits on the amount of debentures it could issue.

Even as it sold more securities to the public, Metropolitan's financial position deteriorated. In fiscal 2000, the company lost $7.6 million, and the next year it lost almost $9 million. Retained earnings were $33.4 million in 1999; by March 2002, they had turned to a loss of $4.3 million.

In a September 2000 filing with the S.E.C., Metropolitan stated that its ability to repay interest and principal on debt securities and preferred stock dividends depended in part on "the success of future public or private offerings of debt and equity securities." In other words, the company was paying off existing investors and lenders with money from new buyers of its securities.

Despite its dire financial position, Metropolitan continued to attract investors. In January 2002, the company listed a series of preferred stock on the American Stock Exchange. That year, preferred stock and debentures outstanding rose to $371 million from $252 million in 1999. The debentures paid interest rates of 5.75 percent to 8.75 percent, depending on when they matured. Those rates attracted retired investors living on fixed incomes. Although Metropolitan's securities were listed on two national exchanges, the debentures rarely traded. That meant that if holders needed to sell before their investments matured, they were unlikely to find buyers.

CONCERNED that Metropolitan was spinning out of control and that investors in her state would be hurt, Ms. Bortner wrote a 14-page letter to the S.E.C. in the fall of 2002. Her letter, addressed to Lori A. Richards, the S.E.C.'s director of compliance, inspections and examinations, outlined her office's extensive and troubling experiences with the company and urged the commission to scrutinize Metropolitan's operations.

The S.E.C. declined to say how it responded to Ms. Bortner's letter. As is its custom on such questions, it would not disclose when it began investigating Metropolitan's operations. But in November 2003, investigators in the San Francisco office of the S.E.C. requested documents from both Metropolitan and Summit and their auditor, Ernst & Young, indicating that an investigation was under way.

The company, meanwhile, appeared to become desperate for capital. For the nine months ending last June, Metropolitan recorded $20 million in losses. That compared with a loss of $6.3 million during the period a year earlier. By last June, the commercial loans made by the company that it considered troubled had grown to almost 20 percent of the total, from less than 3 percent in the previous year.

During those nine months ended last June, Metropolitan raised $76 million in debenture bonds and issued an additional $22 million in preferred stock.

The company began asking some of its 420 workers to buy preferred shares that summer, said one long-term employee of Metropolitan who has since been laid off. Company officials told the workers that if enough people bought the shares it could list them on an exchange, according to the former employee. Because so many Metropolitan workers were already investors in the company, this person said, many were comfortable putting up more money.

By fall, as the company approached its 50th anniversary, it began unraveling. On Oct. 20, NASD, the self-regulatory organization overseeing the brokerage industry, settled a proceeding against Metropolitan's brokerage arm, Metropolitan Investment Securities Inc., after contending that it had engaged in fraudulent, deceptive and unethical practices while selling securities issued by Metropolitan and Summit. Brokers selling the securities did not fully discuss the risks associated with the instruments and used misleading sales literature, NASD found. "Tired of LOW Bank Rates? Compare Ours," was the headline on one advertisement cited by regulators.

NASD censured the brokerage firm, fined it $500,000 and ordered it to set aside $2.9 million for restitution. So far, NASD has identified just 163 investors for remuneration. The agency is putting the proceeds from the fine -- plus another $500,000 paid by the company -- into the fund for aggrieved investors.

As word of trouble at Metropolitan seeped out, its investors started coming into company headquarters to try to cash in their bonds before they had matured. "People would come into the office when I worked down in front and say, 'We are really upset about our money and we can't get it out,"' the former employee recalled. "Some of those people were so devoted to Metropolitan that they would never do anything but keep their money in Metropolitan."

In mid-December, the American Stock Exchange suspended trading in the company's securities. On the day after Christmas, the securities were delisted. Mr. Sandifur resigned as president and chief executive on Jan. 27, although he remains on the board. Metropolitan and Summit filed for bankruptcy a week later.

On Feb. 9, the S.E.C. asked the bankruptcy court to name an independent examiner to determine whether the company's management engaged in fraud. "We take this action today to safeguard the interests of the more than 35,000 investors who purchased stock and bonds in Metropolitan and Summit," said Helane L. Morrison, the S.E.C.'s district administrator in San Francisco.

DOUGLAS SIDDOWAY, a lawyer at Randall & Danskin in Spokane who is representing Metropolitan investors in the bankruptcy proceeding, called the collapse a bigger financial trauma than any he had seen in the region. "What makes it particularly painful is that these securities should never have been offered to most of these investors in the first place, given their stations in life. The trick now is to get the companies reorganized so that their subsidiaries can continue to sell life insurance and annuities. And, once that's done, go after the people and institutions that may be responsible for the losses."

It will take months, if not longer, for investigators to sort through the wreckage of Metropolitan. Ms. Richards at the S.E.C., who received Ms. Bortner's warning letter in the fall of 2002, said she did not think that the Metropolitan debacle exemplified a lapse by federal regulators. "There isn't a void in oversight here," she said. "There is an enforcement investigation; there's a listing review by the stock exchanges and the division of corporation finance review," she added, referring to a division of the S.E.C. She also noted that the commission had not allowed new securities offerings registered by the company last year to proceed. If they had gone forward, investors' losses could have been far larger.

And Shelley E. Parratt, deputy director in the division of corporation finance at the S.E.C., said that it was not the commission's job to pass judgment on the merits of an investment. "Our oversight is very different," she said. "It's a full disclosure regime, not a merit regime."

But that is small consolation to the many investors who put their entire savings into Metropolitan securities. Ms. Bortner said she is convinced that if the company had not slipped from her office's regulatory grip, investors would not be facing the losses that they do. "When a company is selling notes they have to demonstrate they can repay those notes -- that's always been the standard of the state regulators," she said. "But that is not a standard that they implement on the federal level."